Tax Tips When You Acquire Software

If you’re in the market for new software for your business, you have several options at your disposal. Specifically, you might buy off-the-self software from a vendor, lease the software from an outside firm, buy it “bundled” with hardware, acquire the software as part of a business deal, or develop it yourself.

What are the tax ramifications? It depends on which option you use. The basic guidelines for deducting computer software costs were spelled out a few years ago in a landmark IRS ruling (Revenue Procedure 2000-50). Here’s the skinny.

Off-the-shelf software: This is the most common method of obtaining new software. You can literally pick off the software from a computer store’s shelves or purchase it online. As a general rule, your business is required to amortize the cost over 36 months. A recent tax law change permitted businesses to currently deduct off-the-shelf software under Section 179. This tax break was extended through 2010 by the Hiring Incentives to Restore Employment (HIRE) Act.

Leased software: If you lease software, it’s comparable to renting office space. You can currently deduct the lease payments as “ordinary and necessary” business expenses. But it may be difficult to find an outfit providing software that meets your needs at a reasonable cost, so you’ll have to shop around.

Bundled software: Typically, any new computer equipment you buy will include some software as part of the package. If you only require “plain vanilla” software for your business, this may be sufficient. Generally, the entire cost of the hardware (including any amount attributable to software) may be deducted over five years. However, if you separate out the software cost, you can write it off over three years or deduct the full amount in one year under Section 179.

Corporate software: Suppose your business acquires another company’s specialized software as part of a business transaction. In this case, the tax law requires you to amortize the costs attributable to software over a 15-year period.

Developed software: Finally, if you have the know-how, you may develop software in-house. This allows you to customize the software to your specific needs. The cost may be deducted currently as long as you treat it consistently on the books. Alternatively, if you create an asset for the business, you may elect to amortize the costs over 60 months.

Note that consistency is a key. If you’re going to switch gears—for example, you want to unbundle software from hardware—you must obtain IRS approval for an accounting change.

Reminder: You can derive tax deductions for computer software if you operate a business. Unfortunately, there are no tax breaks for software used for a personal laptop or computer.

This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.